Rss Feed Tweeter button Facebook button Delicious button
What would happen if everyone invested in index funds - Julio Urvina

What would happen if everyone invested in index funds

By Mark Hulbert

Published: May 8, 2017 5:11 a.m. ET

The arithmetic of active management is sobering

Roughly 20% of the combined value of all stocks today is in index funds.

CHAPEL HILL, N.C. (MarketWatch) — Alexander Pope wasn’t referring to trying to beat the stock market when he wrote that «hope springs eternal.» But he very well could have been.

That’s because, no matter how overwhelming the statistics are showing that broadly diversified index funds outperform almost all active managers over the long term, investors and advisers continue to believe that they can beat the market in the future.

Don’t fall for their arguments.

Consider their latest, which has gained increasing popularity in recent years: Because so much money is now invested in index funds, it has become markedly easier to beat the market.

To be sure, this argument on the surface does have a certain amount of plausibility: Market efficiency depends on investors pricing stocks according to their anticipated profitability, and index funds do not engage in this so-called price discovery. If 100% of investor assets were invested in index funds, therefore, it presumably would be a lot easier to identify which stocks are over- or undervalued.

There are a number of problems with this argument, however. The first is that we are nowhere close to this hypothetical extreme. Currently, for example, perhaps 20% of the combined value of all stocks is owned by total-market (or almost total market) index funds. Even if it’s that high, that would still mean that 80% of the market — or nearly $20 trillion currently — is actively engaged in trying to beat the market. That’s a whole lot of price discovery.

The second, and even more basic, problem with the hope-based argument is a matter of simple arithmetic: Active managers on average will always lag the market, period. We owe this crucial insight to William Sharpe, who won the Nobel Prize in Economics in 1990. He introduced the argument in a 1991 article in the Financial Analysts Journal: «The Arithmetic of Active Management

Sharpe’s reasoning is elegantly simple and unassailable. He starts by pointing out that the combined portfolios of all active managers and investors must equal that of the entire market. That’s because total-market index funds themselves own each stock in the proportion that their individual market caps are of the entire stock market. Take away those index funds, and the actively managed portion that remains must collectively equal the market as well.

Sharpe’s second point is that active management is more expensive than passively investing in a total market index fund. It therefore follows «as the night from the day» that, net of fees, «the return on the average actively managed dollar will be less than the return on the average passively managed dollar.»

Lawrence G. Tint is currently chairman of Quantal International, a risk-management firm for institutional investors, and formerly was president of Sharpe-Tint, a consulting firm with William Sharpe. In an interview, Tint pointed out to me that Sharpe’s argument isn’t at all dependent on market efficiency or a low percentage of the entire stock market being invested in total-market index funds. It is equally true regardless of whether this indexed percentage is 10% or 90%.

Tint added that it’s theoretically possible that particularly shrewd managers will find it easier to beat the market when and if the indexed percentage grows markedly from current levels, impacting the market’s normal price discovery. That would be the case, for example, if, as business opportunities for active managers decrease, all but a few shrewd managers leave the business and mostly mediocre ones remain.

But, Tint quickly added, we have no way of knowing in advance if this will be the case. That’s because the market has never been in a similar situation in the past, and it’s just as theoretically possible that when the indexed percentage grows it’s the mediocre managers who leave the industry. In that case, it could become more difficult for even shrewd managers to beat the market.

The bottom line: It is absolutely certain that the average active manager will lag behind the market in the future, regardless of how much of the entire stock market gets invested in index funds. Though it’s theoretically possible that shrewd managers will find it easier to beat the market when the indexed percentage grows to a higher level, it’s entirely speculative whether this will actually be the case.

That’s a very slim possibility on which to base your hope of beating the market. You need to balance that small shred of hope against the overwhelming statistical case that, over many decades, the percentage of active managers who have consistently beaten the market is close to zero.